How to improve returns from the idle cash lying in Saving/Current Account

We should not let our money idle in the savings bank account, it can be invested to earn a better returns without compromising liquidity or taking high risks.

After demonetisation about  Rs ten lakh crore is deposited in the last three weeks, the savings bank accounts of Indians are bulging with cash. As government has put restrictions on withdrawals, a large chunk of this money is going to stay put for the next few months, earning a paltry interest of 4% per year. Though the interest on the savings accounts is tax free up to Rs.10,000 per year,  Still it's not a good idea to keep Rs. 2.5 lakh idling in your bank account. The interest it will earn won't be able to beat inflation, and the purchasing power of money will come down. Of course, this money was losing value faster when it was lying in your locker as hard cash.

We have various options to deploy this idle money to earn higher returns without compromising liquidity or incurring high risks. The choice should depend on how soon the money will be needed and income tax bracket and also the willingness to make a little effort.

1. Bank fixed deposit

The simplest and easiest way to deploy saving/current account bank balance is to open a fixed deposit, though the returns may not be very exciting and Banks have already slashed the interest rates on short-term deposits. A one-year deposit in the State Bank of India will now fetch only 4%, which is equal to what a savings bank account earns. The rates for longer term deposits are little higher, but mind it the interest earned on fixed deposits is fully taxable. If an investor is in the highest tax bracket, the post-tax return could be even less than saving interest rate. Also, unless we have a online/Netbanking account, opening a fixed deposit won't be easy at a time when visiting the bank is like entering a war zone.

The best way out is to open a long-term deposit of 3-5 years and break it when money is required, we can also keep small denominations FD so that it can be used if only a part of the money is needed. Most of the banks no longer levy a penalty for premature withdrawals. But interest rate to be paid will be applicable rate for the period we remained invested, which is usually lower than the longer-term rate. Also, if the interest income exceeds Rs. 10,000 in a year, the bank will deduct TDS.

This is fine if a person’s income is above the basic exemption limit of Rs. 2.5 lakh per year. But investors in the zero tax bracket will have to file their returns to get a refund of the TDS, or submit the Form 15 G or H to escape the TDS.

Now for recurring deposits too, the interest earned is fully taxable. These deposits were not subject to TDS, but the rules have now been amended.

An investor can also consider opening a sweep-in bank account, where any excess amount in savings account automatically flows into a fixed deposit. If we withdraw from savings account, the fixed deposit is automatically broken.

2. Liquid funds and ultra-short-term funds

Mutual fund is another smart way of earning more income without compromising on liquidity. We can invest in liquid mutual funds. These are ultra-safe schemes that can deliver up to 7-8% returns in a year. The biggest benefit is that the income from mutual funds is treated as capital gains and taxed at a lower rate if the investment is held for at least three years.

They are also more flexible. We can withdraw small amounts whenever required or invest more when we have surplus cash. Now various online platforms are available through which we can invest and redeem very easily and instantly.

The risk of losing money in a liquid fund is almost negligible. The investment is also very liquid. If you redeem before the cut-off time (usually 12.30 pm), the money is in your bank account the next morning at the latest. There is no minimum investing period either. Some mutual funds also offers instants redemption by which money can be credited to an investors account within 30 minutes (upto Rs. 2 lakhs) including holidays and Sundays.

3. Short-term debt funds

Those who don't need the money for the next 6-12 months can opt for short-term debt funds. These are also debt schemes, but invest in a mix of short term and medium-term bonds. The returns are slightly higher than what liquid funds and ultra short-term debt funds give, but there is also an exit load payable if we redeem before a minimum period that ranges from 3-12 months. In few schemes, the minimum investment period can be up to 36 months. Before investing we should check the exit load of the income fund or where a penalty of 0.5-1 % can pare the returns.

In the current scenario as interest rates are expected to decline, these funds can give attractive returns in the short to medium terms. Even in the long term, they will give better post-tax returns than fixed deposits. However, these funds also carry an interest rate risk. Of late these schemes have delivered good returns because interest rates have been consistently declining. If interest rates rise, these funds can decline, resulting in losses.

4. Arbitrage funds

Arbitrage funds are for those Investors who can hold for one year or more as they offer tax-free returns. These funds invest in stocks and equity instruments but don't carry market risk. The gains are taxed at 15% if redeemed within one year however dividend received is tax free. After one year, the capital gains are  also tax free. Before investments we should also check the exit load of the arbitrage fund, otherwise the penalty of 0.5-1% can pare the returns.

5. Monthly income plans

If an investor can bear certain degree of risk, monthly income plans (MIPs) from mutual funds can be a low-risk entry point to the equity markets. MIP schemes follow a conservative investment strategy, allocating only 10-25% of their corpus to equities and putting the rest in safer bonds and instruments. Their returns are better than debt funds, though they also carry a moderate risk. These funds have exit loads so check the terms and conditions.

Bank deposits were traditionally the only and safer option for the investors to keep money and withdraw as per convenience however now when the bank FD rates are historically low and there is lot of awareness regarding mutual funds, we should look at various type of mutual funds which can give safety as well as better returns compare to traditional products. 

As Bank FD Rates Fall, Where should we Invest in…

Over the past two years, RBI has reduced benchmark policy rate by 175 basis points (bps) to 6.25%. This has resulted into fall of FD rates offered by banks and also Small Saving Schemes viz. Public Provident Fund (PPF), NSC, postal savings schemes etc who have reduced the rates and  disappointing many investors who are looking to earn fixed returns. 

Bank FD’s were offering 8-9% just a couple of years back which has gone down to below 8% now.

The impact of falling interest rates…

For example if we have invested Rs. 10 lakhs in a one year FD earlier where it was fetching 9/5% quarterly compounding return it would have given annual interest of Rs 98438 (quarterly compounding) But with the current FD rates hovering around 7.5%, our yearly return on fresh deposits will be approximately Rs. 77136 – which is Rs. 21302 less as compared to earlier returns. Further this is taxable income so TDs may be deducted and we have to pay tax as per the slab rates. this is excluding tax.

So If we are placed in the highest tax bracket, the net yield from the bank FD will be in the range of 4.5-5%. Therefor if we calculate the real rate of return (also known also as inflation-adjusted return)  on FDs it will be actually negative considering 5% normal inflation rate.

Especially for Senior citizens, who depend on interest income to fund day-to-day expenses, this is a serious concern for managing their investments.

Hence, its demand of time to find out other options which can be used alternatively in place of Bank FDs and Small Saving Schemes.  Although we understand that bank fixed deposits or Small Savings Schemes are considered safe and easy to manage instruments still there is no dearth of fixed income products available which can give better risk return output. However As riskier assets command a higher yield; so here too, risk cannot be ignored. There is a gamut of other available investment avenues: corporate fixed deposits, corporate bonds, tax-free bonds, and debt mutual funds; albeit the fact that they command higher risk vis-à-vis bank FDs and SSS. Here are the pros and cons of each of these options. 

1. Corporate fixed deposits and corporate bonds: Corporate FDs and bonds earn you a higher interest than bank FDs. Currently they offer returns in the range of 8-9%. However, we should remember, the higher yield comes with a higher risk. The risk of default in corporate FDs cannot be ignored. So while investing in Corporate FDs ratings and reputation of company should be seriously analyzed and only top rated companies should be considered for investments. Due to the poor regulatory framework, there is little respite if the company fails to earn back your hard-earned money.

2. Tax-free Bonds: Tax-free bonds are a good long-term fixed income option, especially if investor is in the highest tax bracket and able to subscribe to the bonds in the primary market, as and when they are offered. As the name suggests, the interest earned on these bonds is tax-free. These bonds can be bought/sold in the secondary market also; however, liquidity can be an issue. Currently, there are no tax-free bonds available for subscription in the primary market, but as the financial year draws to a close, we may find quite a few in the offing. In the secondary market, the bonds are trading at a yield of around 6-6.25%. The post-tax returns work out better than the current bank FD rates; but liquidity may be an issue, or if yields move up, the possibility of a loss of capital cannot be ignored when sold prematurely.

3. Debt mutual funds:  Based on the fund investment mandate, debt funds invest in different securities such as government bonds, corporate bonds, corporate deposits, etc. with different maturities. In mutual funds the returns are not guaranteed as the investments are market-linked. However, if carefully invested in, debt schemes work out to be a better option than those we have discussed above. The following are the main features which makes it better than other options:

a)     Diversification: Mutual funds helps to diversify the investment even if it is as small as Rs. 5000. As a individual investor we can not buy may bonds/debentures with limited amount however mutual funds has the advantage to invest the pool of money in various securities. Hence, our risk too, will get diversified over multiple securities by investing in single scheme. But before investing in a debt mutual fund scheme, we should analyse the latest portfolio holdings to check whether the schemes are well-diversified and if they are invested in high credit rated assets.

b)     Liquidity: Most debt schemes have an exit load period of a few months to a year. Therefore, if we redeem our investment before this period, we will be charged an exit load or penalty. The exit load ranges from 0.25% to 1% depending on the scheme. This is similar to the premature penalty charged by banks on fixed deposits. But the exit load instils discipline in investments. Besides, most debt schemes are fairly liquid and able to meet redemption requests on a day-to-day basis. This is where debt schemes score over corporate FDs, which have a fixed lock-in period or tax-free bonds where we have to search for a buyer on the exchange.

c)     Benefit from falling yields: if interest rates continue to fall the net asset value of debt mutual fund scheme will move higher. Hence, we will earn higher returns on our investment. When yields fall, the price of a bond rises and vice versa hence the NAV of schemes goes up. If we see past one year’s performance those who invested one years back has go decent returns on account of the falling yields. The average return over the past year of higher maturity debt schemes, works out to around 9.5-10% which is much better than bank FDs. However we should also understand that, if yields go up, the bond price will fall and so will the NAV of the debt mutual fund scheme you invest.

In current time when there is space for accommodative policy (abetted by inflation), interest rates in the economy are expected to go downhill. Another 25-50 bps reduction cannot be ruled out in time to come if inflation data remains benign.

To manage very short-term liquidity needs, where the investment horizon is fairly short i.e. less than a 3 months, money can be parked money liquid funds vis-à-vis savings bank account. For short-term investment horizon of 3 to 6 months, ultra-short term funds and/or arbitrage funds can be considered for investments.

 

d)   Tax benefits: This is where debt funds score over bank FDs and other taxable interest bearing investments. The interest we earn on bank FDs is added to our income (under "income from other sources") and gets taxed as per our income tax slab, irrespective of your holding period, further tax is deducted on source (TDS) if interest income is more than 10,000/- in case of Bank FDs and Rs. 5000/- for Corporate FDs . However, in the case of debt schemes, if our holding period is three years or more, the gains are taxed at 20% with indexation. With the indexation benefit, post-tax return will work out to be far more tax efficient than in case of bank FDs. For any period less than three years, the gains will be added to the income and taxed accordingly. Before investing in a scheme, we should check if the yield is higher than the current bank FD rates, whether it has good quality of assets in the portfolio, and if its average maturity is equivalent to your investment horizon.

e)     Professional management: In Mutual funds, fund manager will manage the quality, diversification of securities and we don't need to worry about these things. Based on the investment objective of the scheme, the fund manager is expected to vary the investment accordingly. We can always select a scheme based on performance track record on a host of parameters, and also assess how the fund manager has done his job. If schemes under him have done well, we can expect the performance to continue. This professional management does come as a cost in the form of expense ratio or fees. Most debt schemes charge an expense ratio of around 1%. We should keep an eye on costs as well before selecting a debt scheme.

 Remember:

·      Although Bank FDs and Small Savings Schemes are safe and easy to manage, but in the current scenario the post-tax returns are not encouraging

·        In a falling interest rate environment, debt funds are expected to perform better than bank FDs.

·        Debt funds are more tax efficient as compared to bank FDs if held for a period of 3 years or more.

Arbitrage Mutual Funds: Another Smart way of earning high tax free returns in short duration

If I ask any one of us generally about safe and tax efficient short-term investment avenue to park surplus money other than the fixed deposit, most of us will answer “Liquid Funds are the best for a short-term investment”.  Many of us believe that Liquid Funds are the best alternative to Fixed Deposit which might be true also for some case. But is it really true always? Are Liquid Funds the best tax efficient option to park short term funds (three months and more).If your answer is ‘Yes’ then you must read below to understand why Liquid funds are not tax efficient short-term investment avenue.

The convenience and better absolute returns from the Liquid Fund for very short-term, even for overnight investing is very significant. This makes it attractive even though there is no tax advantage as for all debt based mutual funds (liquid fund is a debt based mutual fund) we have to pay short term capital gain tax based on the slab rate if it is redeemed before three years. So if a person is at highest tax slab, he has to pay almost 1/3^rd of the income as capital gain tax, in a way tax liability is similar to the FDs.

So what could be another option to get better returns without risking the capital?

Answer could be the Arbitrage Funds. Arbitrage Fund leverages the price differential in the cash and derivatives market to generate returns. The returns are directly dependent on the volatility of the asset class i.e. Equity Market. However, It would still be market neutral i.e. No specific equity risk as they would be buying and selling the stocks simultaneously in cash & future market.

These funds are hybrid in nature as they have the provision of investing a small part of the portfolio in debt markets.

Arbitrage Mutual Funds are mainly for low risk-taking investors. In a situation of high and persistent fluctuation, Arbitrage Funds offer investors a safe opportunity to park their hard-earned money. These funds take advantage of the Equity market inefficiencies and secure profits for the. These funds invest primarily in equities; hence their tax treatment is same as equity mutual funds.

What is Arbitrage and how they earn?

As the name suggests, Arbitrage means encashing the inefficiencies of two markets. In equity market these are the price differences between cash segment stock price and future segment (F&O). These funds encash the opportunity (which we call as arbitrage opportunity) of the price difference in these market. The difference in these market exists due to insufficient flow of information between two market prices and time value of money however it is temporary in nature. Sometimes due to huge buying/selling in the particular segment of stock or huge volatility in market generates arbitrage opportunity.

There are various reasons due to which these price differential exists like stock specific news i.e. quarterly or annual results, corporate governance issue, bulk buying or panic selling etc. these events generates arbitrage opportunity because of the relative price difference in cash and future market. Generally Arbitrage Fund uses hedging strategy; they buy stock from cash market and sell those stocks in the future market to lock price difference between two segments of the market.

Arbitrage strategies followed are different for different asset management companies; some may adopt strategies like Index/Stock cash – Index/Stock future, ADR/GDR, Buy-Back Arbitrage, Hedging and Alpha strategies, cash-future arbitrage strategies or corporate action or event driven strategies. When fund manager feels market having very less volatility or arbitrage opportunity, he may invest a sizeable amount in debt or money market securities to generate stable returns.

So how it works?

Assume that price of XYZ stock is quoting at Rs. 100 in the cash segment, whereas the price in the Future market is Rs. 101. At this point of time fund manager, can make the profit by purchasing stock in cash segment and selling an equal number of shares in the future market. So after doing this translation fund manager locks in Rs 1 profit per share on the day of settlement without getting worried about daily price movement or market directions.

Investment done is the cost paid for cash market buy and margin value of the future contract. Profit will be booked on the day when stock price of both the market match or on the last day of settlement and the fund manager will reverse his position in stock, he will sell stock holding in cash segment which was purchased and will buy contract in the future segment.

Mostly returns generated by schemes are based on the efficiency of fund manager’s opportunity spotting skill and trade execution skill of his team. Cash price and Future contract price generally converges at the end of the month, so he will make very low risk return of around 12% [(101-100)*12/100].

Who could be the investors?

Arbitrage mutual funds are alternate to liquid/short term funds and mostly suitable for parking money for the period of 1 month and above. These funds are basically locking available spread, so return are purely dependent on arbitrage opportunity available at particular point of time. Arbitrage Funds have exit loads generally in the range of 7 days to 3 months, it should be kept in mind before investing. Another important aspect is Arbitrage Funds are mildly fluctuating in the short run, sometimes even 1-month scheme return do not look attractive compared to Liquid Fund, ultra or short-term income fund. Monthly returns of Arbitrage Funds are always volatile due to monthly expiry at different spreads.

These funds are for parking short term cash and are not long-term wealth creators. Arbitrage Fund do not invest like other equity-oriented schemes, they do not take any directional bet on Equity market, they just lock the spread available between two prices at same point of time, hence Arbitrage Funds are not for the long-term wealth creation. So an investor should use it as a liquid investment and do not make it a major part of the portfolio.

Arbitrage Funds are mostly suitable for those investors who are in 20% or 30% tax bracket. If an investors investment horizon is less than 1 year, go with the Dividend option and investor who wish to stay invested for more than 1 year and less than 3 years should go with Growth option. An investor who is willing to invest for more than 3 years can also look for growth plan of the Liquid Fund, FMP, Ultra short-term or short-term mutual fund also.

How it benefits the investors?

For those investors who are in 10% tax category, Liquid Fund returns are in their favour compare to Arbitrage Fund returns and that is because of tax treatment on a capital gain (Short Term Capital Gain tax is as per slab rate). But for investors, who are already paying 20% or 30% income tax, due to the adverse tax treatment of debt mutual fund, their actual post tax earning will be very less if invested in Liquid Funds. Hence any return you earn after holding it for 12 months is tax free, and in case you hold it for less than 12 months and make any profits, the taxation is 15% (short term capital gains tax) however the dividend received anytime is tax free.

Investment Horizon	Debt Mutual Funds		Arbitrage Mutual Funds
	Dividend Distribution Tax	Capital Gain Tax	Dividend Distribution Tax	Capital Gain Tax
Upto 1 Year	Individual 28.84% Company 34.61%	Income Tax Slab	NIL	15%
Between 1 and 3 Years	Individual 28.84% Company 34.61%	Income Tax Slab	NIL	NIL
After 3 Years	Individual 28.84% Company 34.61%	20% less indexation	NIL	NIL

For example an investor who is paying 30% income tax (ignoring surcharges for the sake of simplicity) invests in Liquid Fund for the period of 6-month to park surplus money. After six months of investment, his post-tax return would be much lower compared to return generated by Arbitrage Fund (here we have assumed 8% annualised return in liquid funds and 7.5% in Arbitrage funds based on current returns). He will be earning merely 2.8% post-tax return from the Liquid Fund scheme against 3.8% post-tax return from Arbitrage Fund. If he has invested Rs. 10 lakhs for six months, just by keeping the funds in arbitrage funds instead of liquid funds he would be earning Rs. 9500/- extra which is 34% more as compared to liquid funds.

Particulars	Liquid Fund	Arbitrage Fund
Annualised Return	8.0%	7.5%
Tax Slab	30.0%	30.0%
6 Months Return	4.0%	3.8%
Tax on Returns	1.2%	-
Net Return	2.8%	3.8%
Amount invested for 6 Months (Rs.)	10,00,000.00	10,00,000.00
Net Income (Rs.)	28,000.00	37,500.00
Difference in Income (Rs.)		9,500.00
% Difference		33.9%
Tax Slab is taken the highest bracket and ignore the surcharge for the sake of simplicity

It is clear that by selecting the correct investment vehicle considering time frame and individual’s tax bracket, one can actually get much higher returns by doing his homework properly and understanding the tax treatment of different class of mutual fund schemes.